The Case Against Digital Transformation

Last week a friend of ours told me a story about trying to get some support for his partner who was ill. He was stuck in an impasse between the NHS, the Department of Work and Pensions, and Social Services.

He kept being told that either he, or the GP, or his employer, or her employer, had not supplied some piece of information. Two of the agencies blamed the NHS. The NHS blamed him.

The repeated interactions he was having with people and departments who wouldn’t, or simply couldn’t, speak to each other reminded me of the closing lines from I, Daniel Blake:

‘I am not a client, a customer, nor a service user. I am not a national insurance number, nor a blip on a screen.’

He described the slow progress he was making against systems seemingly designed to make it as difficult as possible for him to succeed.

What really made me think though was the resignation in his voice as he said – “They just don’t seem to listen to what I’m saying – they only believe what’s on their screens.”

Myth #1: Every part of an organisation should digitally transform.

Not every company, process, or business model requires or is benefited by digital transformation.

Perhaps it’s time to pause the relentless cheerleading for transformation and consider the cost of digitising everything.

What does society look like when each and every interaction with citizens has to be digitally verified?

Today in business it’s heretical to suggest that it’s sometimes easier just to pick up the phone and have a conversation with someone. Big consulting has been very quick to point out the inefficiencies of talking to people – the implication being that everything is cheaper and easier online.

Are we allowed to mention that cheaper is not always better?

The digital revolution has meant lots of things but there’s precious little evidence it has improved customer service. On the contrary, as Gerry McGovern writes in his latest post, customer experience is flatlining. Organisations have often used technology to boost short-term profits with none essential expenses (like people) being reduced, outsourced or replaced altogether by machines.

The rush towards technology implies everything can be made better when the meddling influence of people is minimised. Even if that were true the data systems we replace them with are designed by people – and inherit many of our human flaws. We rarely ask to get a second opinion on what our data is telling us.

A better starting point might be considering the case against digital. Which part of your customer experience are you unwilling to automate and make more efficient?

First Direct – one of the UK’s first and arguably best online financial service – have deliberately made their telephone service easier to use than any other bank. That’s conscious design, deliberately adding cost to the business with the trade-off being improved customer experience.

A couple of years ago we did an experiment where we sent two colleagues out to meet with customers – devoid of any technology. What we perceived would be a huge barrier to the test turned into a net gain – the colleagues told us it enabled them to have a better conversation by not having to repeatedly look at screens. We liked the results so much we built an entire service around it.

Ultimately we have to change the leadership model, not the technology. Customer experience isn’t all about efficiency, systems and protocol. It’s letting people do what they do best — knowing customers, personalising service, surprising people with the unexpected.

Being a leader in the digital era means resisting the insistence for efficiency at all costs – and deploying digital methods where it actually improves the outcome and experience.

Rather than the continual celebration of change and transformation, we should spend more time considering its social cost.

Multi-Factor or Not Multi-Factor? That Is the Question

Let’s pretend you are a US investor that wants to deploy some of your money overseas. You think international developed market stocks are attractive relative to US stocks, and you also think the US dollar will decline over the period you intend to hold your investment. Your investment decision is logical to you. But you have choices: You could a) simply invest in a traditional index like the MSCI EAFE, b) invest in a fund that systematically emphasizes a single factor (like a value fund) that only buys specific stocks related to that factor, or c) invest in a developed fund that blends several factors together, like the JPMorgan Diversified Return International Equity ETF (JPIN). What is the best choice?

Investing in a traditional international market capitalization index like the MSCI EAFE is not a bad choice. It has delivered nice returns for a US investor, especially uncorrelated outperformance in the 1970s and 1980s, and helped to diversify a US-only portfolio.

Your second choice is to invest in one particular factor because it makes sense to you. Sticking with the example of a value strategy, you might believe a fund or index that chooses the cheapest or most attractively valued stocks based on metrics like Price to Earnings (PE) is best.

You could go find a discretionary portfolio manager who only buys stocks he deems to be cheap. Typically the concept of “cheap” is based on some absolute metric that the manager has in mind, such as never buying a stock with a PE greater than 15. If there are not enough stocks that are attractive, he will hold his money in cash until he finds the prudent bargains he seeks. This prudence also obviously risks possible underperformance from being absent from the market.

The alternative is to buy a value index or fund that systematically only buys the cheapest stocks in a particular investment universe. So if there are 1000 investable stocks available, the index ONLY buys the cheapest decile of 100 stocks and is always fully invested in the 100 securities that are relatively cheapest. This is an investment approach that a discretionary manger may disdain. The discretionary value manager may look at those same 100 stocks and think they are pricey. But nevertheless, academic research has shown that always being fully invested in the relatively cheapest percentiles of stocks in the US has produced superior returns over many decades.

Such a portfolio is called a “factor” portfolio. Why the name? In the early 1960s, academics introduced the concept of beta and demonstrated that individual US stocks had sensitivities to, and were driven by, movements in the broad market. In the early 1990s, academic research began to show that other “factors” such as value and size also drove US stock returns. Since then, several factors have been identified as driving individual stock outperformance: value, size, volatility, momentum and quality. Stocks that are cheaper, smaller, less volatile, have more positive annual returns and higher profitability have historically outperformed their peers. It turns out these factors also work internationally.

Of all the factors, value is the factor that has been the best known the longest (even before it was academically identified as a “factor”), thanks to the books of Warren Buffet’s teacher Ben Graham. And if you look abroad at an array of developed global markets and create a value index and compare it to its simple market capitalization weighted brother, the historic outperformance of value has been stunning. Until recently.

While there was some variability by country, on average from the mid-1970s up until 2005 a value factor portfolio in a developed market outperformed its market cap weighted index by about 2% a year. That’s a lot. By contrast, since 2005, the average developed country value portfolio has underperformed a market cap indexes by about -40 basis points. Which is the danger of investing in one factor. It may not always work at every point in time.

So if investing in one factor like value runs the risk of underperforming, how about a multi-factor international developed equity portfolio?

Below is a breakdown of individual factor portfolios’ performance in international developed equity markets since 2005, an equal weighted factor portfolio as well the performance of the MSCI EAFE as our performance reference. Note that, for the last 13 years, value has been the poorest factor by far, while the others have handily beaten the EAFE. An equal weighted portfolio of all 5 factors, while not as optimal as some of the individual factor results, beats the EAFE by 1.6% and has an information ratio, or risk adjusted returns that are superior by 37%. The equal weighted factor portfolio also has the advantage of not having to predict which factor will work when, so even when a factor like value does not beat the market, the other factors can pick up the slack.

SOURCE: MSCI, Data as of January 31, 2018. Past performance is no guarantee of future results. Shown for illustrative purposes only.

The equal weighted factor portfolio has one other advantage over the market cap weighted alternative. Note in the chart below how well the portfolio outperformed in the 2008 crisis, so it tends to do relatively well in highly volatile sell offs.

SOURCE: MSCI, Data as of January 31, 2018. Past performance is no guarantee of future results. Shown for illustrative purposes only.

While it’s not inconceivable that one or two of these factors could erode, or underperform for a stretch, the fact that you have exposure to multiple factors in a portfolio that seems to do especially well in crises suggest the multi-factor blended portfolio remains the most attractive way to invest in developed markets.

So, when asked the question: Multi-factor or not multi-factor? The data speaks for itself.

DEFINITIONS: Price to earnings (P/E) ratio: The price-earnings ratio (P/E ratio) is the ratio for valuing a company that measures its current share price relative to its per-share earnings.

DISCLOSURES: MSCI EAFE Investable Market Index (IMI): The MSCI EAFE Investable Market Index (IMI), is an equity index which captures large, mid and small cap representation across Developed Markets countries* around the world, excluding the US and Canada. The index is based on the MSCI Global Investable Market Indexes (GIMI) Methodology—a comprehensive and consistent approach to index construction that allows for meaningful global views and cross regional comparisons across all market capitalization size, sector and style segments and combinations. This methodology aims to provide exhaustive coverage of the relevant investment opportunity set with a strong emphasis on index liquidity, investability and replicability. The index is reviewed quarterly—in February, May, August and November—with the objective of reflecting change in the underlying equity markets in a timely manner, while limiting undue index turnover. During the May and November semi-annual index reviews, the index is rebalanced and the large, mid and small capitalization cutoff points are recalculated.

Investors should carefully consider the investment objectives and risks as well as charges and expenses of the ETF before investing. The summary and full prospectuses contain this and other information about the ETF. Read the prospectus carefully before investing. Call 1-844-4JPM-ETF or visit ww.jpmorganetfs.com to obtain a prospectus.